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It’s That Time of Year: Keep Deferred Compensation in Mind

December 21, 2023

At year end it is common to provide bonuses and additional compensation. A growing part of that compensation is deferred – promised in one year and paid in a later year. The Tax Code provides strict rules for when and how to award deferred compensation. In time for year-end awards and vesting, we are providing four reminders to help with compliance.

When do the deferred compensation rules apply?

Whenever a business promises compensation in one year that could be paid in another year, the deferred compensation rules (known as 409A rules after the Code Section where they are located) might apply. There are limited exceptions, such as for 401(k) as well as other qualified retirement plans, health and welfare benefits, and compensation paid by March 15th of the year after the award vests.

Follow Your Plan Documents

One of the biggest risks is failing to follow the documentation around deferred compensation. The Tax Code requires there to be a written record of deferred compensation that includes the key features, including, without limitation, who receives an award, the amount of the award, when the award will vest, and how payment occurs. The documentation will also provide important definitions from the Tax Code that control how those same terms would otherwise be used. For example, the Tax Code has definitions that must be used for separation of service, termination of employment, disability and change of control. Beyond definitions and documentation generally, it is important to remember that once a deferred compensation award is made, it should be modified or amended only after talking to legal counsel, as changing existing awards is an easy way to create problems which are best avoided.

Avoid Accelerating Payment

The Tax Code has strict prohibitions against speeding up a deferred compensation payment. However, waiving or accelerating vesting is not normally a problem. For example, if deferred compensation vests 20% for each of five years and then pays out at the end of the fifth year, it is normally permitted to accelerate vesting, so long as the award will still be paid at the end of the fifth year. One important exception is when vesting triggers payment. For example, it would be a compliance concern if vesting was accelerated in an award that paid when it vested on the earlier of five years, death or disability. The prudent approach is not to accelerate an award unless it is expressly permitted by the award or if experienced legal counsel has reviewed the circumstances.

Carefully Consider New Deferred Compensation

Even though deferred compensation does not get paid out right away, there are real costs and expectation that come with it. Deferred cash needs to be paid out over time and even synthetic equity, which is based on the value of the company is paid out, normally in cash. This cost is one of the many reasons why it is important, when granting new awards, to consider what type and how much compensation is appropriate for the position and goals. Another important factor is whether awards will be made on a one-time basis or annually. If awards will be made every year, it is worth considering smaller annual awards that when collected over several years, remain at an appropriate or reasonable level of compensation.

Value the Awards Properly

One technical and important aspect of the deferred compensation rules is the proper determination of fair market value for equity-based awards. A valuation that complies with the Tax Code is often required when an award is made or paid out. For publicly traded companies, the trading price is the value. If a company is not publicly traded, the Tax Code establishes guidelines for valuation. These guidelines are technical. Getting help from a valuation expert is important, even if an executive or accounting team has established a valuation for other purposes.

If you have questions about your existing deferred compensation awards or are considering new awards, you can contact a member of the employee benefits team for additional information.

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